Main findings
Stage of development of insurance sector
Use of the Methodology
Observance of ICP and transparency practices of insurance supervisors
ICP assessments and the IAIS self-assessments
Implications for financial sector vulnerabilities

Assessment of insurance supervisory systems in member countries began
in 1999 under the joint Bank-Fund Financial Sector Assessment Program
(FSAP). Evaluations are based on the observance of the Insurance Core
Principles (ICP) issued by the International Association of Insurance
Supervisors (IAIS). The ICP assessments are integrated in Fund surveillance
through the Financial System Stability Assessment (FSSA) and the
Report on the Observance of Standards and Codes (ROSCs).

The assessment process is still at an early stage and is constrained
by regulatory gaps in several key insurance supervisory areas. Further
work is also required on the linkages between macroeconomy and the insurance
sector. However, the findings of the 20 ICP assessments completed so far
under the FSAP are proving useful in identifying insurance-related supervisory
vulnerabilities, as well as development issues such as legal processes,
market discipline, and strengthening insurance skills and resources. Weaknesses
in meeting the preconditions necessary for effective insurance supervision,
divergent accounting, actuarial practices, and the absence of internationally
acceptable standards relating to capital have also raised concerns relating
to the adequacy of insurance supervisory practices. Transparency practices
followed by the insurance supervisors need strengthening to conform to
the internationally accepted good practices.

At present, the supervisory deficiencies identified are not posing
serious risks to the insurance systems in the countries assessed so far.
A number of linkages have been observed which point to the potential for
problems relating to the role of insurance and contractual savings in
systemic stability. The most common sources of potential systemic vulnerabilities
within nonbanks have been equity or guarantee (including credit and mortgage
guarantee insurance) exposures to the banking sector. In general, the
growth of liberalized and competitive insurance markets is posing new
and more complex challenges for the insurance supervisors. The FSAP has
been emphasizing the need for approaching insurance supervisory issues
in an interdisciplinary way.

While the use of the ICP in the broader context of the FSAP is providing
better insights on the overall financial system supervisory vulnerabilities,
there are a number of areas in which the assessment process needs to be
enhanced. The supervisory principles need further work in terms of
clarity and scope. A major gap exists in the degree of specificity in
the principles on prudential issues. A more structured approach is also
required with respect to assessing the preconditions for effective insurance
supervision. The use of the ICP within the FSAP process also needs to
be streamlined. These could include: a more thorough pre-FSAP evaluation
of the significance of insurance to the financial system, structuring
the assessment more specifically to the local environment, and expanding
the scope of the assessment, where appropriate, for a more systematic
consideration of overlapping insurance, banking, and pension system issues.

The detailed findings of this review will be communicated to the IAIS
by the Bank and Fund staff, including suggestions on how the ICP and the
assessment methodology can be improved. Similar feedback will be provided
to the Fund-Bank Financial Sector Liaison Committee (FSLC) to strengthen
the assessment of insurance systems under the FSAP.

1. Insurance and the Insurance Core Principles (ICP) developed
by the International Association of Insurance Supervisors (IAIS) are,
respectively, one of the 11 areas and associated standards recognized
by the Bank and Fund Executive Boards as being useful to the operational
work of the staff. The evaluation of insurance supervisory systems
in member countries, which began in 1999 during the "pilot"
phase of the Financial Sector Assessment Program (FSAP), is based on the
degree of observance of the ICP. Twenty ICP assessments have been completed
so far under the FSAP while an equal number are under way or planned during
FY 2002.

2. The ICP assessments have become a useful component of
the FSAP. A thorough understanding of the insurance supervision system
is assisting in the overall evaluation of the regulatory and supervisory
framework of the financial system.2 Both
the Bank and the Fund are devoting greater attention to regulatory and
supervisory issues pertaining to the insurance sector. The Bank staff
has strengthened its resources in the insurance area and is assisting
client countries in developing their insurance systems. The Fund staff
has also begun making use of the ICP in its technical assistance work
and in the assessment of Offshore Financial Centers (OFCs).

3. This paper analyzes the experience to date with the
assessment of the ICP and the main lessons for the future.3
It examines the usefulness of the assessments in identifying insurance
supervisory vulnerabilities and for the further development of insurance
systems. It identifies areas in which the insurance supervisory practices
need strengthening and where scope exists for improving international
guidance relating to insurance supervision. It also examines the efficacy
of the assessment process under the FSAP and suggests ways in which the
quality of the assessments can be improved.

4. The IAIS, which has recognized the Bank-Fund assessments
as an instrument for getting feedback on the ICP, has also requested input
for the forthcoming re-examination and possible revision of the ICP planned
by the IAIS in 2002. The IAIS and the Bank and Fund staff continue
working cooperatively on a number of issues of common concern and this
relationship has become particularly important with respect to the implementation
of the ICP (see Box 1).

5. The remainder of the paper is organized as follows:
Section II discusses the development of the insurance sector and the
main supervisory approaches; Section III describes the ICP; Section IV
details the assessment process and presents the main findings of the ICP
assessments, examines how the evaluation of insurance supervisory practices
have been incorporated in the overall financial stability assessments,
and analyzes the recommendations typically given by ICP assessors to improve
observance; and Section V identifies areas in which the assessment process
could be strengthened and where the scope could be expanded to cover gaps
in international guidance relating to insurance regulation and supervision.

Box 1. The Bank and Fund
Staff and the IAIS

The association of the Bank and Fund staff
with the activities of the IAIS was motivated by three factors:
(1) the integrated evaluation of financial systems under the
FSAP that required appraising insurance supervisory vulnerabilities;
(2) the extension of the cooperative and collaborative arrangements
with international financial sector standard-setting bodies
under the Standards and Codes initiative; and, (3) a better
understanding of the international regulatory issues emerging
from trends relating to financial convergence between the
banking and insurance sectors.

While the initial phase was a less formal
one, both the Bank and Fund staff were given Observer Member
status of the IAIS in October 2000. Observer status is accorded
to organizations, other than insurance regulators/ supervisors,
as part of the IAIS' cooperative efforts at working with other
relevant international financial entities. These include international
organizations, industry associations, insurance companies,
insurance brokers, or accounting firms.

A collaborative role has emerged particularly
with respect to the implementation of the ICP. The ICP and
the assessment Methodology have also been used in the context
of the Fund-led assessment of the Offshore Financial Centers
(OFCs) and in the development of a methodology to enhance
the assessment of financial standards relevant for countering
money laundering under the FSAP and the OFC assessments.

The IAIS is one of the Cooperating Official
Institutions under the FSAP and is facilitating the assessment
process by identifying practicing insurance experts who can
undertake assessments. Further, to assist in monitoring the
implementation of the ICP, the IAIS has set up a Task Force
for Monitoring the Implementation of Standards, with representation
from the Bank and Fund staff. The Bank and Fund staff have
also been working with the IAIS on issues of common concern,
including strengthening and promoting the implementation of
the ICP. The Bank is carrying out research on the impact of
contractual savings on stability and economic development.

The IAIS is also a member of the Financial
Stability Forum (FSF) and the Joint Forum, and works closely
with the Basel Committee. At present, the IAIS is made up
of insurance supervisors from 150 jurisdictions.

II. Insurance Sector and
Supervisory Approaches

A. Insurance Sector Development and Financial Stability

6. Insurance companies are an important and growing segment
of the domestic financial sector in most developed and some developing
countries. In the 1990s, total assets of insurance companies in developed
countries grew faster than those of banks. The liberalization of the financial
systems underpins this trend, marked by privatization, increased use of
contractual savings products, financial consolidation, and full or partial
funding of pension systems. In a number of countries, rapid life insurance
industry growth is a result of the convergence of the life insurance and
contractual savings sectors.4 Recent studies5
show that, while in the early stages of economic development insurance
expenditures relative to GDP are low, as per capita income in countries
increases, the importance of insurance in the national economy tends to
increase rapidly, reaching a saturation point at around the current stage
of development of the insurance industry in developed countries.6
Therefore, one can expect that the importance of the insurance sector
in the global financial system is likely to continue to increase.

7. Resilient, well-regulated insurance systems contribute
to financial stability and efficient resource allocation. Insurance
plays a role in supporting economic and financial development as a provider
of protection from financial loss due to the occurrence of certain contingent
events. This allows investors to enter into commitments that they might
not have otherwise been prepared to consider. Accordingly, the insurers'
efforts at mitigating risk and to make transfer of risk more affordable
and manageable contribute to financial development. In addition, borrowers
and issuers of equity have access to a pool of funds that insurance companies
are willing to invest for the long term, thus contributing to the development
of capital markets.7 Conversely, in some
member countries, the lack of catastrophe insurance can represent an economic
vulnerability and impede development through the need to divert public
resources after a disaster occurs.

8. The growing internationalization of insurance and the
need for enhanced cross-border supervisory coordination are creating new
challenges for the supervisory authorities. Moreover, some of the
recent trends such as demutualization, financial convergence, the role
of the insurance industry in the credit derivative markets, and insurance
as part of large complex financial groups are also raising new regulatory
and supervisory issues. These developments, and the need for better understanding
of the implications for the financial system, would require greater attention
to systemic stability concerns relating to the insurance sector. The IAIS
will have to take an increasing role in order to continue providing guidance
in these areas.

9. Systemic concerns8 have
emerged from the insurance industry, largely because of ownership linkages
between the banking and insurance sectors9
or because insurance sector distress has directly affected the availability
of claims payments to key sectors in the real economy (Table
1). In only a few such instances have the authorities used public
funds to assist in the resolution of systemic problems. Except in overly
prescriptive jurisdictions, insurers tend to have different strategies
or risk characteristics. In particular, the differences in risk characteristics
and risk management practices between life and general insurance
can be substantial. The failure of a general insurance company, for instance,
could interrupt certain services because of the loss of insurance protection
for users of these services.

B. Insurance Regulation and Supervision

10. In many countries, including some industrial countries,
effective insurance prudential regulation for the insurance industry has
emerged only in the last two decades. In the past, some insurance
supervisory approaches were based on the control of insurance products,
pricing, and policy conditions as the basis for calculating the value
of policyholder liabilities. Other supervisors used techniques based on
solvency monitoring. During the 1990s, several supervisory authorities
have increasingly adopted a market-based solvency monitoring approach,
which appears to be gradually gaining universal acceptance.

11. Insurance supervisors began working together at the
broad international level less than a decade ago and are primarily concerned
with policyholder protection rather than systemic risk or development
issues. This approach has strongly influenced the development of the
internationally recognized regulatory principles. The underlying philosophy
of modern insurance supervision is to identify problem companies early,
act promptly, and apply effective intervention. This requires solvency
margins, which are large enough to provide the time needed to resolve
problems so that policyholder benefits are protected. Discussions are
under way to set explicit international guidance on capital requirements
(see Box 2).

Table 1. Examples of Systemic Events
Arising from Insurer Failure

Country (Insurer)

Year

Nature of Crisis

Ireland
(Insurance Corporation of Ireland-general)

1985

The Insurance Corporation of Ireland
(ICI) came close to formal liquidation because of poor underwriting
in its London branch and under reserving. Its parent at the time was
Allied Irish Banks (AIB) and the failure of a major subsidiary could
have caused a run. The Irish government purchased the company from
the AIB and appointed an administrator.

Australia
(HIH Insurance-general)

2001

HIH was a major liability underwriter
in Australia. It collapsed in 2001 and an administrator was appointed.
HIH was a major insurer of builders' liability and its demise disrupted
conditions in the already weak construction sector. The failure of
HIH also disturbed a number of other sectors, especially those which
depend on professional indemnity insurance.

Korea
(Insurance savings products)

1998-2001

Korean life and general insurers were
encouraged to sell short-term savings products, some of which had
deposit characteristics. Competition from banks and trust companies
led to an interest rate war at a time of neutral or negative cash
flows and massive deficits began to emerge. To prevent a run, the
government guaranteed insurance liabilities. Much of the industry
has since had to be wound up, or recapitalized by the government and
sold.

Jamaica
(Life insurance sector-savings products)

1996

The Jamaican life insurance industry
had significant equity and fund flow cross-linkages with the banking
sector, and was in some cases selling deposit equivalents as well
as taking on major property exposures. A weak banking sector thus
became exposed to an insolvent insurance industry and a rare case
of insurance/banking contagion emerged. The government set up an asset
management company, which has issued paper to fill balance sheet gaps.

12. While the insurance industry is changing in response
to the demand for new products and services, the management and control
of the insurers have not necessarily evolved as rapidly. As a result,
there continues to be a wide range of practices in use for measuring and
managing the risks in life and general insurance. In addition, there is
continuing discussion between the industry and the supervisors about how
the recent changes should translate into new practices and standards within
the industry.10

Box 2. Capital, Accounting,
and Actuarial Practices

At present, there is no equivalent to the
Basel Capital Accord in the insurance sector. This is mainly
due to the complexity in developing common standards that
deal with the variety of insurance liabilities and asset combinations
available. Accounting standards for insurance firms can vary
markedly both in terms of the treatment of accruals and the
rigor between (and within) countries. In addition, there is
as yet no international actuarial standard for valuing policyholder-related
liabilities, which is the single most important item in an
insurer's balance sheet.

The differences in accounting and actuarial
practices constitute a fundamental challenge for the work
necessary to harmonize financial reporting standards that
recognize the unique features of insurance, while meeting
the needs of capital market participants and insurance supervisors
alike. Insurance differs from banking in that the major liabilities
do not emerge from a deposit or debt ledger; instead, they
have to be estimated using actuarial or other techniques.

Actuaries have developed measurement techniques
to value policyholders and other liabilities. However, more
work needs to be done to establish common international standards
and to ensure that all aspects of the insurance business are
covered. This work has to recognize the diverse nature of
the insurance products and services that are offered. In some
general insurance cases, the uncertainty attached to the liabilities
can be considerably greater than that arising from the assets
side of the balance sheet.*

The IAIS has issued draft general principles
for consultation with its members on Capital Adequacy and
Solvency (expected to be adopted in September 2001). However,
these still do not specify qualitative requirements. They
do recognize that the issue is complex and requires harmonization
of international accounting, actuarial, and capital standards.

* General insurance usually involves a contract
covering one year of risk; however, claims may take many years
to settle and can involve expensive litigation. Life insurance
usually covers multiple years of usually more predictable
risk (other than market risk) and has an ongoing premium stream.

13. Reinsurance is a significant part of both life and
general insurance. An important aspect of general insurance is the
extent and the global nature of reinsurance. At best, reinsurance is only
lightly regulated in most countries but represents one of the major assets
on the balance sheets of many general insurers.11
The global general insurance industry remains heavily exposed to a small
number of internationally active reinsurance companies based in Bermuda,
Germany, Japan, Switzerland, United Kingdom, and the United States. Most
have traditionally maintained very conservative accounts. However, capital
market pressures for more 'efficient' use of capital, including a growing
demand for transparency, tends to reduce capital ratios within these companies
which could be having a negative effect on the overall security of the
insurance sector.

14. The regulation of these institutions remains a controversial
issue among insurance supervisors and the IAIS is working to develop standards
in this area by 2002. While there is an agreement that the reinsurance
arrangements that direct-writing companies have in place should be subject
to supervision, there is disagreement on the extent to which the reinsurance
companies should be supervised. However, even in countries where reinsurance
firms are actively supervised, the focus is on contractual and prudential
issues and the industry generally deals with the market conduct aspects
of reinsurance.

III. IAIS and the ICP

15. The IAIS was established in 1994, some two decades
after its banking and securities equivalents, and became a standard-setting
body in 1996. The latest version of the ICP and the Insurance Core
Principles Assessment Methodology (Methodology) was adopted by the IAIS
members in October 2000.

16. The ICP provides a framework of 17 supervisory principles
that need to be in place for effective insurance supervision. The
IAIS regards these principles as essential supervisory and regulatory
principles that all countries should implement. These include: governance
issues, prudential requirements, information exchange, and sanctions (see
Appendix I). A number of supporting documents (IAIS standards) have also
been subsequently developed (licensing, on-site inspections, and derivatives),
and new standards continue to be developed (reinsurance, solvency margin
requirements).

17. The ICP Methodology strengthens the framework established
by the ICP document in several ways. It provides an explanation of
each principle in terms of its purpose and the elements that need to be
reflected in the implementation. It prescribes a scheme for assessing
the effectiveness of the insurance supervisory regime by prescribing over
200 assessments "criteria" comprising elements based on sound
supervisory and regulatory practices. The IAIS also has recognized that
assessments initiated by the Bank and the Fund "provided an opportunity
to test both the applicability, clarity, and completeness of the ICP,
as well as the degree to which an outside assessor could form an opinion
regarding observance of the principles."

IV. ICP Assessment Process
and Findings

A. Assessment Process

18. The assessment of the insurance supervisory system
under the FSAP aims at: (1) identifying gaps in insurance sector regulation
and supervisory practices; and (2) providing input for the overall stability
assessment of the financial system. The main instrument used to achieve
these objectives is an assessment of ICP observance (the ICP was issued
by the IAIS in 1997 and revised in 2000). This is combined with the risk
analysis of the broader financial system to establish vulnerabilities
of the insurance sector.

19. Of the 20 ICP assessments completed so far under the
FSAP, three of the early assessments were done using the 1997 version
of the IAIS insurance supervisory principles, while the rest were based
on the expanded version of these principles published in 2000 (Table
2). Thirteen ICP assessments have used the Methodology as a tool in
the assessment, whereas the other seven were completed prior to its development.
The countries assessed included five advanced, seven developing, and eight
transitional countries; the insurance sectors in these countries are at
various stages of development. While the small size of the sample precludes
the drawing of any definitive conclusions, useful observations have been
possible on the insurance supervisory vulnerabilities, their potential
impact on financial stability, and in identifying development needs of
the insurance system.

20. A range of tools was used in undertaking the assessments,
the most important being the Methodology. The Methodology requires
an assessment of supervisory processes not to be done in isolation, but
after taking into account the risks and vulnerabilities from macroeconomic
developments facing the insurance sector. Active use is also made of any
self-assessments done by supervisory authorities prior to the FSAP, relevant
laws and regulations, interviews and discussions with supervisory authorities,
other domestic regulatory bodies, groupings of actuaries, accountants,
and auditors, and licensed insurance firms. To establish cross-sectoral
linkages and form a view on overlapping issues, the assessors also discuss
their findings with the banking and securities regulators.

21. Thus far, assessments have mainly involved staff from
the Bank, supported by the Fund staff. Assessors have also been drawn
from the Cooperating Official Institutions and, in some cases, after consultation
with the IAIS. All assessments have mainly been carried out by at least
one experienced insurance supervisor. However, in the recent period, use
is being made of two assessors where so dictated by country-specific factors
such as the size of the insurance sector, the presence of complex financial
institutions, or where development needs are great.

22. The assessors have adapted the application of the ICP
to the stage of development of the insurance system. They have recognized
that supervisory processes in different countries often reflect the local
culture and attitude toward insurance, as well as the national authorities'
ability to rely on the work of insurance accountants, auditors, and actuaries.
In some cases, therefore, the assessors have modified the minimum set
by the Methodology and assessed the country against the standard that
the assessor felt the country should achieve. In many cases, they interpreted
the ICP in slightly different ways, especially while assessing the principles
relating to Changes in Control, Liabilities, Sanctions, and Cross-Border
Business. This assessment calibration appears necessary given the
differences in the systemic significance of the insurance system. Differing
interpretations should, however, get minimized as the IAIS progressively
sets supervisory standards underlying the ICP.

23. Assessors are strengthening the macroprudential analysis
underlying the supervisory framework. Recent assessments have begun
making systematic use of insurance-related financial soundness indicators
to assist in the analysis of the insurance supervisory vulnerabilities.
These include: ratio of the liabilities of life insurance companies to
total bank deposits; ratio of the government bonds held by the insurance
industry to the outstanding domestic debt; and ratio of total insurance
premiums to GDP.

1/ Date of first mission in the country. Most FSAPs
were organized in two missions.
2/ IAIS Methodology was adopted in October 2000, but FSAP assessors
have used drafts of the Methodology in ICP assessments since May
2000.
3/ Percentage ratio of total insurance premiums (life and general)
to GDP.
4/ Based on Swiss Re. data for 76 countries.
5/ 1997 data.
6/ 1998 data.
7/ Unweighted average.

B. Assessment of Preconditions

24. The Methodology identifies a set of preconditions for
effective insurance supervision. These include: a sound legal and
accounting system; procedures for resolving problems in insurance companies;
effective market discipline; and sound and sustainable macroeconomic policies.
There is, however, no explicit supervisory principle in the ICP document
relating to the overall framework of insurance supervision.

25. Noting, however, that shortcomings in the overall conditions
of insurance supervision may significantly impair the ability of the insurance
supervisor to implement the principles, the Methodology requires assessors
to evaluate the degree to which the identified preconditions are met and
indicate potential problems stemming from any shortcomings. The Methodology,
however, does not prescribe a basis to evaluate these preconditions. This
remains a major limitation of the ICP and the Methodology, particularly
as these preconditions cover issues that are generally outside of the
control of the supervisor (operational independence, political interference,
legal protection for supervisors). Future assessments should consider
actions that supervisors can take to mitigate the effect of the preconditions
that are not fully satisfied.

26. Assessments of the preconditions for effective insurance
supervision reveal that some countries partially met the preconditions
for effective insurance supervision, with qualifications related to the
fact that while good laws were either in the process of being adopted
or recently passed, they have not been tested in practice, or that the
familiarity with the laws was weak. In some countries, assessors concluded
that the judiciary system was weak, laws were outdated, and there were
few qualified professionals (i.e., actuaries, accountants, auditors, and
financial analysts). In a few cases, while the laws were outdated, the
judiciary system was found to be satisfactory and some qualified professionals
were present.

C. Assessment of the ICP

Main findings

27. Supervisory areas in which country practices were assessed
to be generally satisfactory with respect to the ICP are: Financial
Reporting; Cross-Border Business Operations; Capital Adequacy and Solvency;
Sanctions; Prudential Rules—Liabilities; and, Confidentiality.
The most commonly identified strengths were:

Financial Reporting: Financial reporting requirements are set
within the country and companies were required to file financial reports
with the supervisory authority at least quarterly; audited financial
reports were required annually.

Cross-Border Business Operations: All foreign companies are
required to be licensed to sell insurance in the country.

Capital Adequacy and Solvency: Supervisory authority is able
to prescribe capital and solvency standards that companies are required
to meet.

Sanctions: Many supervisory authorities have broad powers and
a wide range of sanctions ranging from fines to licensing restrictions
and de-licensing. Supervisors, however, often have limited discretionary
powers and can only apply sanctions in the event that the company violates
the law.

Prudential Rules—Liabilities: Supervisory authorities
can set the basis for the valuation of liabilities. This is done either
directly by the supervisory authority, through another branch of government,
or through a domestic actuarial standard-setting body.

Confidentiality: Staff of the supervisory authority is subject
to professional secrecy requirements, and required to maintain the confidentiality
of supervisory information.

28. It may be noted though that the satisfactory assessment
of the supervisory practices relating to liabilities was mainly
due to the fairly accommodating wording of the ICP. The formulation
is broad enough to capture a wide range of established practices. To observe
the principle, a supervisory authority must have powers to set the method
and basis for the valuation of policy and other liabilities. However,
the principle does not require that the authority be applied to any particular
prudential standard. This is an important area that requires more work.

29. Areas in which supervisory practices were identified
as weak include: Organization of an Insurance Supervisor; Changes in
Control; Corporate Governance; Internal Controls; Prudential Rules-Assets;
Reinsurance; Market Conduct; and Derivatives and Off-Balance Sheet Items
(Table 3). The most frequently cited shortcomings
in the implementation of the principles in these supervisory areas were:

Changes in Control: The supervisor is often notified in advance
but: there are no clear criteria for denying a change in control; supervisory
approval is not required; or the supervisor has no authority to deny
a change in control. In some cases, the supervisor is not notified in
advance of a change in control.

Corporate Governance and Internal Controls: Lack of a description
of the role and responsibilities of the board of directors of insurance
companies in relevant legislation and regulations; and supervisors do
not have the authority to define the role of directors. The most commonly
identified reasons for non-observance or less than full observance of
the principle on internal controls were the need to establish or strengthen
risk management, asset-liability matching, and the supervisors' lack
of authority to enforce an internal control regime in companies.

Sources: Detailed assessments of observance of
ICP from FSAP reports and staff estimates.

1/ In percentage of the number of countries in
which the CP was found to be applicable and was assessed.

Prudential Rules—Assets: Need to strengthen the investment
rules and exposure limits for assets. In a few cases, the concern was
that the investment rules were too limiting for reinsurance companies,
which constrained the development of the market.

Reinsurance: In all but one case, the identified shortcomings
relate to the inadequacy of the supervisors' power to review or set
standards for the use of reinsurance by direct-writing companies. In
some instances, the assessor was also concerned that the supervisory
authority needed greater power in setting retention limits (that is,
a limit on the insurance risks that the direct-writing company would
keep before seeking reinsurance protection).

Derivatives and 'Off-Balance Sheet' Items: Need to define or
strengthen the rules for the use of derivatives and the disclosures
made by insurance companies in respect of their use of these instruments.

Market Conduct: Need to ensure that insurance companies establish
a complaint-handling system and supervisors need to have their role
clarified and strengthened in this area.

Stage of development of insurance sector

30. The stage of development of the insurance sector in
the countries that were assessed varied substantially. Shortcomings
in the observance of ICP in countries in which insurance plays a bigger
role in the financial system can have a far greater impact on financial
stability than in countries in which it is underdeveloped. Furthermore,
supervisors in these two groups of countries face quite different challenges
in exercising their responsibilities.

31. To gauge the impact of the stage of development of
the insurance sector on ICP assessment findings, countries were grouped
according to their relative standing on insurance penetration. Insurance
penetration is used as a proxy for the stage of development of the insurance
industry in a country relative to the global trends in the insurance business.

32. The results indicate that the degree of observance
of ICP in countries with the most developed insurance sectors was significantly
higher than that in countries with least developed insurance sectors.
The degree of observance of ICP in countries in different intermediate
stages of development of the insurance industry is quite similar, but
significantly lower than that of countries with the more developed insurance
sectors. The incidence of non-observance of ICP in the areas of Corporate
Governance, Prudential Rules—Assets, Reinsurance, Internal Controls,
Derivatives and 'Off-Balance Sheet' Items, Market Conduct, and
Changes in Control in countries that fall in the fourth quartile of
the world distribution of insurance penetration was much more frequent
than in countries with more developed insurance sectors.

Use of the Methodology

33. The use of the Methodology from May 2000 as the main
tool for conducting the ICP assessments has had a significant impact on
the assessment process. Comparison of the distribution of assessment grades
in ICP assessments conducted with and without the use of the Methodology
shows that its adoption has resulted in a more systematic approach and
uniformity in the assessment of the countries' supervisory practices.
The major benefit from the Methodology has occurred in determining supervisory
vulnerabilities relating to Licensing, Corporate Governance, Organization
of an Insurance Supervisor, and Capital Adequacy and Solvency.

Observance of ICP and transparency practices of insurance supervisors

34. In conjunction with the ICP assessment, assessments
are also being made of the transparency practices of the insurance supervisor.
The assessment is undertaken with reference to the IMF's Code of Good
Practices on Transparency in Monetary and Financial Policies (MFP Transparency
Code).12 A high degree of observance
of ICP is associated with the high degree of observance of the MFP Transparency
Code in the area of insurance and supervision and vice-versa.

35. Transparency practices of insurance supervisors are
strongest in the area of public availability of information on financial
policies, whereas transparency practices related to assurances of integrity
of the insurance supervisor are most deficient. The most commonly
identified shortcomings include: internal governance procedures are not
publicly disclosed; cooperation and information-sharing agreements with
other supervisory agencies are not transparent; publication of audited
financial statements of the insurance supervisor is not done on a preannounced
schedule; some of the procedures for appointment, terms of office, and
removal of insurance supervisory officials are not publicly disclosed.

ICP assessments and the IAIS self-assessments

36. The IAIS initiated a self-assessment program based
on the Methodology in October 2000.13
By the end of May 2001, nearly 61 percent of the members had responded.
Ten of the twenty countries that underwent ICP assessment under the FSAP
agreed to have the IAIS share their self-assessments with the Bank and
the Fund. The analysis of the differences in the assessment of observance
of ICP between the ICP assessments and the IAIS self-assessments highlights
some interesting patterns of how insurance supervisors assess their performance
relative to peer assessments.14

37. On average, five of the seventeen core principles were
assessed differently between the ICP assessments and the IAIS self-assessments.
In about 60 percent of the cases in which differences arose, countries
assessed their insurance supervisory practices higher than the FSAP assessor,
while in the rest the opposite was true. Four countries contributed disproportionally
to the total number of differences in assessments. ICP assessments under
the FSAP carried out in the absence of the use of the Methodology tended
to assess countries' supervisory practices more flexibly in almost all
areas. A possible explanation for the relatively large number of cases,
in which countries assessed their observance of core principles more conservatively
than the FSAP assessors, is that all IAIS self-assessments were based
on the Methodology, whereas some ICP assessments were not. Supervisory
areas, in which countries' practices were most often assessed better in
the self-assessments were: Licensing; Prudential Rules-Assets; On-Site
Inspection; and Sanctions. Conversely, country practices in
the areas of Derivatives and 'Off-Balance Sheet' Items; Reinsurance;
and Corporate Governance were most often assessed more conservatively
in the IAIS self-assessments.

38. Overall, compared to the ICP assessments, the IAIS
self-assessments have tended to focus more on formal observance with legislation
and regulations and less on shortcomings in the enforcement of the existing
supervisory framework. The emphasis is primarily from the point of
view of the insurance supervisor rather than the insurance system as a
whole so as to bring out issues relating to the operational independence
of the insurance supervisor, or the extent of political interference that
may be hampering the objectivity of insurance supervision. Another important
aspect relates to the emphasis given under the FSAP in evaluating the
supervisory regime within the context of the industry structure and the
extent to which observance is adequate to address the emerging risks in
the financial system.

Implications for financial sector vulnerabilities

39. The ICP assessments are being used by the Fund staff
as input into the stability assessments and by the Bank staff in the assessment
of the overall development needs of the financial system. The assessment
findings reveal several potential sources of supervisory risks and vulnerabilities.
Two issues affecting stability have emerged. First, several assessments
noted the stability risks emanating from weakness in the supervisory coordination
among insurance, banking, and securities supervisors. While this was mainly
in the case of countries where financial conglomerates exist or are gaining
importance, the findings have a general application. The insurance supervisor
needs to monitor, along with other sector supervisors, the systems for
risk identification and risk management across financial groups. A second
area relates to strengthening the regulations relating to the prudential
framework and its enforcement. These relate particularly to liabilities,
where weak supervisory practices and requirements could conceal institutional
weakness. In several cases, the ICP assessments cited the interconnectedness
of financial institutions (insurance companies and banks) as having the
potential to lead to a systemic problem. In one case, the issue highlighted
was the failure of the supervisor to sign MOUs with foreign supervisors,
given that most of the insurance companies were owned by foreign companies.

40. In a few cases, the assessments did not raise any stability-related
concerns despite the countries' low level of observance of the ICP.
This was due to the small size of the insurance sector relative to the
other constituents of the financial system. In a few instances, the framework
provided by the ICP was found inadequate in assessing the financial system,
which was characterized by financial conglomerates and complex financial
structures. In some cases, it became clear that the supervisory authority
was not yet ready for a full ICP assessment under the FSAP and that a
more comprehensive assessment of the preconditions of insurance supervision
would have been more effective.

V. ICP Assessment Recommendations

41. Each ICP assessment identifies areas in which the supervisory
authority should make changes to strengthen insurance supervision.
ICP assessment recommendations have two objectives: (1) to strengthen
supervisory practices where weaknesses are identified; and (2) raise the
quality of insurance supervision in areas where, even though countries
met the requirements of the ICP, additional steps could further foster
the development of a sound insurance sector. An analysis of the supervisory
areas where recommendations were most frequently made was undertaken by
groups of countries based on the stage of development of their insurance
sectors. The patterns in the clustering of recommendations by broad areas
of supervision support the view that assessors have addressed both objectives
of this part of the assessment process. There is a clustering of recommendations
in supervisory areas that were identified as weak in a significant number
of countries (see Section IV.C).

42. Several recommendations were also made to strengthen
the preconditions. These included the need to strengthen the legal
infrastructure, supervisory resources, accounting, and disclosure practices.
In addition, recommendations were also made in areas where observance
of the ICP was assessed to be satisfactory but scope existed for further
development. While some of these recommendations address shortcomings
in observance of the ICP, others attempt to raise the quality of insurance
supervision above the prescribed minimum. The most commonly made recommendations
related to Organization of an Insurance Supervisor, Licensing, Prudential
Rules, and Corporate Governance:

Organization of an Insurance Supervisor: Increase the number
of staff in the authority; improve the quality of staff (training and
recruiting) and the supervisory framework; enhance the independence
of the supervisor; strengthen indemnity of the supervisory staff.

Licensing: Increase the supervisor's authority and role; strengthen
licensing criteria; tighten up the rules on composite companies; set
rules for changes in control to be similar to licensing requirements.

Prudential Rules: Strengthen investment rules and limits; upgrade
rules for valuation of liabilities; strengthen capital requirements;
define rules for the use and disclosure of derivatives; enhance supervision
of reinsurance arrangements.

Corporate Governance: Clarify or define what is expected of
boards of directors; establish risk management practices.

VI. Follow-Up on the ICP
Assessments

A. National Authorities' Views on ICP Assessments

43. The degree to which the assessment process has the
support from each country and the extent to which the national authorities
are willing to take corrective action is an important part of the FSAP
process. Feedback from national authorities shows that the assessment
process was found to be useful in the implementation of the ICP. The assessments
have provided impetus and direction to national authorities' ongoing efforts
to bring their insurance legislation and regulatory framework in observance
with internationally accepted supervisory practices. Several countries
report difficulties in the implementation of the principle relating to
Corporate Governance. This is mainly due to the lack of development in
the local standards of general business practice or legislation. The "Fit
and Proper" test and "Coordination and Cooperation with Other
Supervisors" are also mentioned as being difficult to implement by
a number of countries. In addition, some countries reported resistance
on the part of the insurance industry to changes in regulations introduced
as a consequence of the recommendations based on the ICP assessment.

B. Technical Assistance

44. Usually, the assessments list recommended actions that
should be assigned priority from the perspective of addressing short-term
vulnerabilities or reform required to strengthen the overall supervisory
framework. These have provided a good basis for independent follow-up
by the supervisory authority or by requesting follow-up technical assistance
from the Bank and the Fund. In several cases, the countries have reported
that the recommendations helped them to formulate their own policy priorities.
In three of the twenty cases assessed so far, follow-up technical assistance
has been provided. These have been in the areas of insurance legislation,
regulation, and organization of the insurance supervisory body.

45. The Bank and Fund staff have also received from the
IAIS a request for technical assistance identified by the supervisory
authorities as follow-up to the IAIS self-assessments completed recently.
These have been in the areas of insurance legislation, setting up the
insurance supervisory agency, corporate governance, and prudential regulations.
The Bank and Fund staff are in dialogue with the IAIS on the scope and
modalities of such technical assistance and ways in which it can be integrated
with the pre- and post-FSAP work.

VII. Concluding Observations

46. The FSAP provides the ICP assessments a useful context
for assessing stability and development needs of the insurance system.
The macroeconomic and financial vulnerabilities, coupled with a complete
assessment of the bank and securities market supervision, allow the insurance
sector findings to be placed in perspective. Some further analytical work
is, however, required with respect to how insurance enhances financial
system efficiency and affects financial stability. Further, while the
Methodology should remain the main tool for assessing insurance supervisory
systems, the assessors need to supplement it with other IAIS standards
and guidance while evaluating risks and vulnerabilities specific to individual
jurisdictions. This is especially important while conducting assessments
in more complex insurance markets, given the gaps and the need for further
improvements in the ICP and the Methodology.

A. Preconditions Assessment

47. Assessment of the preconditions is a critical element
of the assessment process. However, the criteria for assessing the
preconditions for effective insurance supervision need urgent attention.
The assessment experience reveals that in cases where significant shortcomings
in the preconditions for effective insurance supervision are identified,
the focus of the FSAP review could be better directed at reviewing ways
to strengthen observance with the preconditions. This would assist the
assessment process in focusing in on the key issues that would strengthen
the insurance supervisory system.

B. Areas for Improving the ICP and the Methodology

48. The use of the ICP as a tool in the FSAP needs to be
enhanced in several areas. While the ICP sets out the powers and responsibilities
that insurance supervisors should have, they do not specifically require
that supervisors implement and use these supervisory powers. Some of the
principles cover a broad topic while others deal with a narrow issue.
The principles dealing with prudential issues (assets, liabilities, capital
and solvency, and reinsurance) need to be developed further. Three broad
areas in which the IAIS could therefore initiate work to improve the ICP
are: increase the scope of the ICP (market conduct); improve the clarity
of the ICP (organization, licensing, cross-border operations); and remove
overlapping criteria (confidentiality). Critical to the success in developing
and defining sound international standards in these areas is the work
that is under way with the International Accounting Standards Board and
the International Actuarial Association. As such, these standard-setting
bodies should be encouraged to continue to place importance to their work
in setting international standards for insurance enterprises.

C. Linkages to Stability

49. In considering the assessment findings and the relationship
between the observance with the ICP and financial stability, it became
clear that more experience and a well-defined macroprudential framework
relevant for the insurance sector is necessary in order to make a determination
of the important linkages. However, the assessments clearly show that
the risks to insurance stability is greater in situations in which the
preconditions for effective insurance supervision are not fully met and
there is less than full observance with the prudential principles. This,
together with a high insurance penetration ratio, could indicate an important
supervisory vulnerability. In addition, in the course of carrying out
the FSAPs, a number of potential systemic issues15
have been identified, some of which have quite subtle operational modalities.
The issue of financial stability and systemic risk will gain prominence
during the ICP assessments of more complex insurance markets. It also
points to the need for further improvements in the ICP and the development
of a taxonomy of systemic exposures in the nonbank financial sector.

D. Insurance Supervision and Pension Systems

50. In reviewing the assessment findings, it was noted
that several insurance supervisors also had supervisory responsibilities
for pension systems, which were reviewed as part of the FSAP process.
Whereas private pensions normally have limited implications for systemic
liquidity (the potential exception being when banks act as fund managers
and performance guarantees are required by law), they can have significant
fiscal implications where government explicit or implicit guarantees are
granted, and underfunding or investment subsidies are involved. The ICP
does not specifically deal with pensions except to the extent that the
insurance industry provides products that support the provision of pensions.
Guidance is lacking for the insurance supervisors who also oversee the
pension system. Furthermore, there are no international standards for
pension regulation and supervision, although some regional attempts have
been made. However, in future FSAP work, it would be useful, in discussing
the financial sector and the role of insurance, to identify and discuss
the significance of the insurance and pensions benefits and the extent
to which they could impact the resilience and development of the financial
sector.

E. Difficulties in Carrying Out Assessments

51. Several factors have limited the efficacy of the assessment
process thus far. Assessments were influenced by the changes made
in the ICP and the development of various standards underlying the principles.
The shortcomings in the ICP and the Methodology, the measurement problems
in terms of differing accounting and actuarial practices, and the resources
required to actually go beyond assessing formal rules to issues and implementation
and enforcement, have also constrained a uniform approach toward these
assessments. In this regard, the IAIS self-assessment program is a welcome
step and should facilitate the assessment under the FSAP, both in terms
of the preparedness of the supervisory authorities and in fulfilling the
pre-FSAP information requirements. In addition, further work is required
on the ICP and the standards that are linked to these principles, so that
supervisory systems can be strengthened and assessments can be more uniform.

F. Future Work

52. There are two key future tasks, the first of which
is to provide feedback and provide ongoing support to the IAIS as the
ICP evolves in light of emerging experience. Specifically, the areas
identified for further improvements in the ICP should be considered by
the IAIS when the re-examination of the supervisory principles is taken
up in 2002. Their use in providing indications of macroeconomic and financial
vulnerabilities also needs strengthening. The Bank and Fund staff would
provide all possible assistance to the IAIS in this task.

53. The second task is to continue developing the Methodology
(with the IAIS) and the templates to ensure that the ICP assessments are
appropriate and relevant, and carried out in a consistent manner, allowing
for preconditions and the stage of development of the insurance market.
In addition, there is growing evidence that many member countries will
be seeking post-FSAP advice and assistance to upgrade their insurance
regulatory framework and supervisory capacity.

54. Finally, preparation of comprehensive and objective
self-assessments by supervisory authorities, in advance of the FSAP assessment,
would also help the assessment process. In particular, it will facilitate
a more in-depth assessment of the strengths and weaknesses of insurance
supervision, with enhanced focus on implementation, enforcement, and cross-sectoral
issues. The Bank and the Fund are examining opportunities to work with
the IAIS in running training programs for both FSAP assessors and country-level
self-assessors. Progressively, with changes in the regulatory and supervisory
guidance from the IAIS, the tools available for the FSAP will improve,
thus enhancing the objectivity and completeness of the assessments of
the insurance systems of member countries.

Appendix I. Insurance
Core Principles

Organization of an Insurance Supervisor (ICP 1): The insurance
supervisor of a jurisdiction must be organized so that it is able to accomplish
its primary task, i.e., to maintain effective, fair, safe, and stable
insurance markets for the benefit and protection of policyholders. It
should, at any time, be able to carry out this task effectively in accordance
with the Insurance Core Principles.

Licensing and Changes in Control (ICPs 2, 3): Companies wishing
to underwrite insurance in the domestic insurance market should be licensed
and the insurance supervisor should review changes in the control of companies
that are licensed in the jurisdiction.

Corporate Governance and Internal Controls (ICPs 4, 5): It is
desirable that standards, which deal with corporate governance, be established
in the jurisdiction. The supervisor should be able to review the internal
controls and require the board of directors to provide suitable prudential
oversight.

Prudential Rules (ICPs 6, 7, 8, 9, 10): Insurance companies should
meet prudential standards established to limit or manage the amount of
risk that they retain. Standards should be established in the areas of
assets, liabilities, capital adequacy and solvency, derivatives and ''off-balance
sheet'' items, and reinsurance.

Market Conduct (ICP 11): Insurance supervisors should ensure that
insurers and intermediaries exercise the necessary knowledge, skills,
and integrity in dealing with their customers.

Monitoring and On-Site Inspection (ICPs 12, 13): Insurance supervisors
should get the information they need to properly form an opinion on the
financial strength of the operations of each insurance company in their
jurisdiction.

Sanctions (ICP 14): Insurance supervisors must have the power
to take remedial action where problems involving licensed companies are
identified.

Cross-Border Business Operations (ICP 15): The insurance supervisor
should ensure that: no foreign insurance establishment escapes supervision;
all insurance establishments of international insurance groups and international
insurers are subject to effective supervision; the creation of a cross-border
insurance establishment is subject to consultation between host and home
supervisors; and foreign insurers providing insurance cover on a cross-border
services basis are subject to effective supervision.

Coordination and Cooperation (ICP 16): In order to share relevant
information with other insurance supervisors, adequate and effective communication
should be developed and maintained.

Confidentiality (ICP 17): All insurance supervisors should be
subject to professional secrecy constraints in respect of information
obtained in the course of their activities.

1The main contributors to
this paper were Udaibir S. Das, Plamen Yossifov, and John Thompson (Consultant)
from the IMF; and Rodney R. Lester, Donald A. McIsaac, Gordon Dowsley,
and Manuel Peraita (Consultant) from the World Bank.2The relevance of standards assessments in
the context of the FSAP is reviewed in Financial Sector Assessment
Program—A Review: Lessons from the Pilot and Issues Going Forward
(SM/00/263, 11/27/00). 3A similar review on the experience with
the assessment of the Basel Core Principles (SM/00/77, 4/12/00)
and the IMF Code of Good Practices on Transparency in Monetary and
Financial Policies (SM/00/269, 12/1/00) has been undertaken by the
Fund staff.4In a number of countries, it is increasingly
difficult to separate insurance and privately managed pensions, and the
contractual savings sector is large relative to the banking sector. 5See Rudolf Enz, "The S-Curve-Shaped Relation
Between Per Capita Income and Insurance Penetration," Swiss Re., Economic
Research & Consulting, Zurich, Switzerland, 2000.6Factors constraining the growth of the life
insurance sector appear to be high inflation levels and generous government-funded
social security arrangements; for general insurance, market constraints
to growth could include the presence of government monopolies.7See Catalan, M. et al., "Contractual Savings
or Stock Markets Development: Which Leads?," World Bank Research Paper,
August 2000.8For the purpose of this review, systemic
concerns relating to insurance could arise in situations which lead the
authorities to use public funds to manage private sector insurance insolvency,
or exercise management control to maintain or support the contractual
rights of policyholders.9A common and increasingly important linkage
occurs when insurers underwrite credit risk on behalf of credit-granting
institutions. Occasionally, a credit-granting system can become exposed
to a small number of insurers.10These include practices to value liabilities
that arise under new types of products, and the accounting treatment for
financial guarantees and financial reinsurance arrangements. 11Reinsurance is effectively contingent
capital (a form of call option) and most nonlife insurers make heavy use
of this financial instrument to manage risk exposure or to satisfy solvency
requirements.12The IAIS was a member of the Consultative
Group on the Supporting Document to the Code of Good Practices
on Transparency in Monetary and Financial Polices. The IAIS Methodology
lists the Code as one of the key standards that should be reviewed wherever
relevant while assessing observance of the ICP.13The IAIS had conducted a self-assessment
exercise in 1998. However, in the absence of an assessment methodology
and a proper dissemination of the supervisory principles, the self-assessments
could not provide meaningful information on the prevailing insurance supervisory
practices.14In interpreting the results, it should
be kept in mind that all ten self-assessments were done in the period
January-April 2001, during or up to eighteen months after the completion
of the respective ICP assessments under the FSAP.15For example, in one country it was discovered
that 70 percent of all credit insurance (mainly covering retail finance)
was concentrated in one insurance company.